State lawmakers need to be vigilant: Big changes are underway in the payday loan market, many of which will hurt borrowers and socially responsible lenders. Long-term, high-cost payday loans and auto title installment loans have grown significantly as companies diversify their business models in an effort to reduce reliance on conventional payday loans. However, without state-level guarantees, these long-term products often have excessive prices, unaffordable payments, and excessively short or long terms, and therefore can be as harmful to borrowers as conventional payday loans.
What should states do?
State lawmakers who want a well-functioning market for small loans will need to establish strong but flexible collateral to protect consumers and ensure transparency. Lawmakers in states where payday loan shops operate should consider measures similar to Ohio Loan Equity Act (HB 123), which was adopted in July. The law tackles major market problems by lowering prices, requiring payments to be affordable, and giving borrowers a reasonable time to repay. It also includes crucial provisions to balance the interests of consumers and lenders, thereby ensuring broad access to credit.
Table 1
Sensitive Saves Big Step Forward for Ohio’s Small Loan Market
How the state loan equity law tackles harmful payday lending practices
| Problem | Ohio law |
|---|---|
| Loan terms are too short, resulting in unaffordable payments and frequent re-borrowing. | Borrowers will have at least 3 months to repay a loan, or monthly payments on short-term loans will be limited to 6% of the borrower’s gross monthly income. |
| Credit terms are too long, which increases debt and increases the cost of borrowing. | The total cost of the loan will be limited to 60% of the loan principal, eliminating the incentive for lenders to set unreasonably long repayment terms. |
| The prices are much higher than necessary to guarantee widely available credit. | Allows lenders to charge 28% interest plus a reasonable monthly maintenance fee. This price is significantly lower than that of typical payday loans, but durable for efficient lenders, which means that the credit will continue to flow. |
| Entry fees make refinancing expensive and prolong debt. | Demands equal payments made up of principal, interest and fees combined, with strong protections against entry fees. |
Source: Pew Charitable Trusts
Ohio law is not perfect. Ideally, it would have required all secured loans to have payments no more than 5% of a borrower’s gross income (or 6% of net income), capped total costs at 50% of the loan principal instead of 60%. , and banned head-on. charges charged. (Although small, the $ 10 authorized charge to cash the loan proceeds check is a hidden charge that has little or no justification because the lender is not taking any risk in accepting a check that originated from it.) But as The Pew Charitable Trusts explained in written comments For lawmakers, the Fairness in Lending Act is a major step forward in protecting Ohio consumers who take out small loans, and it’s a model for other states that have payday loan stores. The following is a summary of the main issues that the law addresses.
Loan terms are too short
Research has shown that conventional payday loans are untenable because they are due in full too quickly (usually around two weeks) and the required payment consumes a third of a typical borrower’s salary. Additionally, payday lenders are the first creditors to be paid because they can access the borrower’s checking account on payday. While this strong ability to collect payments facilitates the flow of credit to borrowers with damaged credit histories, it also means that lenders generally do not ensure that borrowers can repay the loan and successfully meet their other obligations. financial. To more closely align the interests of borrowers and lenders, state policymakers should ensure that these loans are safe and affordable by limiting monthly payments to 5% of a borrower’s gross salary. In Ohio, as part of the compromise, lawmakers gave borrowers at least three months to repay and limited monthly payments on short-term loans to 6% of gross monthly income.
Loan terms are too long
Small installment loans with unreasonably long terms can result in extremely high costs because only a small proportion of each payment reduces principal; the rest is for interest and fees. For example, a loan of $ 300 with a term of 18 months can result in a total repayment of almost $ 1,800– approximately six times the amount borrowed. To ensure that the repayment period is not excessive, the legislator should limit the total borrowing costs to half of the amount borrowed. So the maximum charge on a $ 300 loan would be $ 150. This would ensure that lenders do not reap additional fees by setting unnecessarily long terms. Ohio lawmakers have limited total loan costs to 60% of the amount borrowed.
Non-competitive prices
Payday lenders charge more than necessary to make credit available, but states can cut costs while still allowing businesses to make a profit. For example, the Colorado reform in 2010 achieved the cheapest payday loan market in the country while maintaining broad access to credit. In 2016, an average installment loan of $ 392 in the state lasted three months and cost $ 119 (129% annual percentage rate, or APR); nonetheless, profitably operating payday lenders in Colorado charge much higher prices to borrowers in other states. In Ohio, payday lenders will be allowed to charge a little more than in Colorado for shorter loans and a little less for those that span six months or more, with APRs automatically decreasing as the loan increases. loan amount increases. This structure creates a well-balanced market and allows loans of up to $ 1,000 without putting consumers at risk.
Upfront costs
Providing a secure installment loan market requires predictable debt exit. Lawmakers can achieve this by requiring that small loans be repaid in substantially equal installments of interest, fees and charges combined, and that upon prepayment or refinancing, all loan fees be repayable on a pro rata basis. which means borrowers would not pay the remaining days on the loan once it has been fully repaid. In contrast, allowing prepayment penalties or upfront fees, such as non-refundable origination fees, is a strong incentive for lenders to push borrowers to refinance in the first few months of a loan and acts as a penalty for borrowers. borrowers who repay the loan early.
Conclusion
State lawmakers can take steps to make small loans safer for consumers while allowing lenders to provide credit and earn profits. That’s exactly what Ohio lawmakers did. If other states want to follow suit, they should adopt measures that address current market problems – using the solutions outlined above – and include in their legislation other consumer protections that Ohio has addressed in its Fairness in Lending Act.
Nick Bourke is the director and Olga Karpekina and Gabriel Kravitz are senior partners in The Pew Charitable Trusts Consumer Credit Project.
